UK & Iceland GDP comparison

After the recent GDP figures from ONS, the general reaction was rather pessimistic. FT had e.g. this tweet and article:

True, this doesn't look good. In fact, after the revisions, UK GDP volume is now further below its top before the financial crisis than Iceland's GDP is. The following graph is based on data from ONS and Statistics Iceland. The top is given the value 100 (3Q07 for Iceland but 1Q08 for the UK). Chained volume measurement, seasonally adjusted (yes, the Icelandic data are SA although they don't look like it).

Back on track: Iceland is edging closer to its GDP volume top before the crisis. The momentum is also stronger.

Iceland's GDP is now 0.4% closer to its top before the crisis than UK's GDP compared to its top. Then again, Iceland had its top two quarters ahead of the UK.

But - there is always a "but" - this is a volume measurement. And although economics teach us to think in volumes and real measurements, we arguably do not rely on barter (and never did) in our commerce. We use money and money is different between economies: try paying with Queen's money in Iceland and you'll be a laughing stock (I've tried, the guy just grinned at me) just as you will be if you try using the ISK in the UK.

So what happens if we price the volume produced in the same currency, say the GBP. That comparison makes sense: we could be producing the same volume as before the crisis but is it worth the same?

The UK volume is already priced in pounds so no need to handle that in a special way. But the Icelandic volume measure uses the ISK as a measurement stick and that measurement stick has changed significantly since before the crisis. If we measure both of the volumes in GBP, the following graph is the result.

Still long way to go: measured in GBP, the Icelandic GDP volume does not seem to be edging must closer to its previous height

Notice the drop in the Iceland data in 2006. This is the "Geyser crisis", a short wake up call to the fact that we were in a bubble. But it did not last long; politicians and prominent businessmen claimed everything was peachy, the housing bubble restarted (held up with exchange-rate linked loans which have now been deemed illegal) and the banks kept on growing. Then, finally, the party ended.

To my British friends I say: sure, you're not in the best of situations. But if it makes you feel better, you're not in the worst.

How much household debt was cancelled? Update

In April last year I wrote about how much of Icelandic households' debt was cancelled. Now, we've got new info on the topic.

And the amount: 247.5 billion ISK. This figure comes from the Icelandic Financial Services Association in their comment on the new government's 10-step plan of general debt relief to Icelandic households (they don't really comment on it, they are going to wait until the government actually describes how they're going to do this).

What are the sources and the reason for the debt relief so far? The IFSA comment has a handy table to show us (my translation). The left-most column is mine as I thought it would be informative to note where the initiative for each part came from. In the cases of where I've put "Legal System" it is due to rulings regarding the illegality of certain credit contracts, first and foremost ISK denominated debt that is indexed to the exchange rate. That sort of indexation is illegal in Iceland since 2001 (though it did not stop the contracts to be created during the height of the credit party). Finally, do note that the figures due to ruling 600/2012 (a supreme court ruling regarding the illegality of certain exchange-rate indexed loans) are estimates and not entirely realised as of yet.

The total debt relief to Icelandic households, 2009-3Q2012.

Despite this nearly 250 billion ISK relief, Icelandic households are still pretty indebted. In the newest Financial Stability report, the Central Bank of Iceland estimated that the outstanding household debt amounted to around 110% of GDP. That is roughly the same ballpark as Ireland is playing in - although the Irish are not paying a 4-5% real rate of interest on their debt as Icelanders do.

From the newest Financial Stability Report (Central Bank of Iceland)

Nevertheless, the debt jubilee has of course had some effects; one should expect that when debt amounting to 15% of GDP is cancelled. But the situation is still fragile and we should not expect it to improve as easily as it did in the early 2000s when an investment boom was creating a lot of jobs and wage income.

Icelandic households' ability to live on after-tax monthly income (source: Statistics Iceland)

Minister of Finance Comments on the Housing Financing Fund

The new minister of finance, MP Bjarni Benediktsson, spoke with Bloomberg the other day. The topic was the Housing Financing Fund and its "red numbers" as Benediktsson put it.

The most notable part of the interview was when Benediktsson wished that creditors of the fund - the owners of HFF bonds - would be "flexible" if and when HFF would request discussions on changing the stipulations on the bonds. The problem with the bonds is that they aren't callable while the HFF mortgages are (in most cases) and have for the last 3 years or so been refinanced with non-indexed mortgages from the banks. The result: HFF sits behind with high-interest debts which aren't callable and truck loads of cash.

Benediktsson guessed in November 2012 that HFF would need perhaps as much as 200 billion ISK from the state but the Fund operates with an avowed state guarantee. The problem is that there is not a single word about state guarantee for HFF in laws about state guarantees. So while it is the "legal understanding" of Benediktsson (who is an educated lawyer I may add) that there is a state guarantee on the HFF bonds, one can easily argue that there is no such formal backup in Icelandic laws.

This is not the first time a politician comments on the HFF situation. In November 2012, trades with HFF bonds were halted twice. The first trigger was a stampede of sellers in the wake of an article in Viðskiptablaðið ("The Business Newspaper") where it was said that the un-callable bonds would have to be made callable to save the Fund. Not a week later, MP Sigridur Ingadottir, commented on the situation, again with Bloomberg, and said it would be necessary to enter renegotiations regarding the stipulations of HFF bonds. Another stampede followed.

In an interview with RUV (The Icelandic "BBC") in November, I pointed that while the state was regularly pumping equity into the Fund - it has gotten 46 billion ISK from the state in new equity since 2010 - the Fund would be able to pay its debts and bondholders could sleep peacefully. But this constant need to pump equity into the Fund would harm the chances of reaching a balanced fiscal budget. And the problem is that a balanced budget is something that is practically a prerequisite for abolishing the capital controls. Both the Central Bank and new minister of finance, MP Bjarni Benediktsson, know this. Abolishing the capital controls is something that is prominent on the "to do" list of the new government. Benediktsson called the capital controls "a flashing warning sign" for foreign investors, telling them to stay away from the Icelandic economy.

So there is an interesting situation brewing. The new minister of finance knows that one of the barriers that he has to cross in order to facilitate the abolishment of capital controls is to get a balanced budget. What is stopping him from doing that is a potential 200 billion ISK bill that arises due to the avowed state guarantee on the Housing Financing Fund. On top of this come a few election-promises such as lowering taxes and financing a debt jubilee to Icelandic households. Endeavouring to mitigate that problem, he wishes that creditors of HFF will be "flexible" when and if the HFF will request negotiations on the stipulations on HFF bonds.

And who are the creditors of HFF? Mainly Icelandic pension funds (64%). Foreigners hold only 4% of outstanding HFF bonds. Something tells me that Icelandic pension funds will never give back an inch when, not if, negotiations on the HFF bonds' stipulations will happen. Something else will have to give in.

A plea to the future government of Iceland

Statistics Iceland released new figures on the labour market recently. According to them, the unemployment rate in Iceland continues to go down. It has reached 5.7% after having reached almost 8% in early 2011.

The unemployment in Iceland is slowly improving. I guess some nations would not complain too much about the rate of unemployment around 6%. 

But here is the catch: even though the rate of unemployment is coming down, the labour market is not improving much.

Next graph shows my point. We can see that during the boom years, the total working hours (estimated by multiplying number of people at work multiplied with the average working hours) increased sharply. This is to be expected as the real capital investments at the time (housing and dam construction to name just two) demanded a lot of labour. This demand for labour was answered by importing workers from e.g. Eastern Europe and China. 

Then came the crash and the total working hours collapsed along with the real capital investments. But so did the average working hours per individual in the workforce!

Despite the improvement in the rate of unemployment, the labour market does not show any other prominent signs of returning to normal levels. 

One reason why is the fact that not all of the foreign workers went back home. They stuck around, got an Icelandic passport, have assimilated into the Icelandic culture and have become Icelanders. Good for them!

The other more prominent reason is the fact that investment is all but gone! Investment as a proportion of the gross domestic product has never been at lower levels than now. I estimate that in order to get up to the more normal 20% ratio of investment to GDP, we need to expand real capital investments in Iceland by almost half: we currently invest around 245 billion ISK annually but we need 120 billion ISK more.

The level of investment in Iceland is puny compared to the level it should be at. We need roughly 120 billion ISK more to get up to the 20% ratio where we can expect the economy to be neither in an investment bubble a la 2005-2007 nor in a serious slump. 

The normal response of politicians in Iceland to too low level of investment has been to promise a new heavy industry project. An aluminium smelter is the classic!

But the track record of heavy industry investment in Iceland hasn't been that great. The energy is sold at too low prices (that was politics) and the negative environmental effects are affecting the more Thirlwall's Law friendly tourism sector. Basically, in the long run, the positive economic (and environmental) effects are more prominent in other major industries in Iceland. The classic "lets build a new smelter!" is a cheap get-out-of-jail card and shouldn't be used, again, if the long term prospects of the economy are to be held in high regards.

Rather, what is needed, is investment carried out by small companies, especially if they are domestically owned and operating in the export industry (as it would generate a much needed foreign currency income into the economy).

Tourism is an obvious choice, especially as it would generate a lot of long-term jobs (which the construction of yet another smelter does not). The long-term growth prospects of tourism are also excellent as the number of middle-income people, which can afford and want to travel, grows tremendously as the Chinese, Indian and other Asian economies grow (Thirlwall's Law kicks in).

Investing in more energy independence would also boost the long term prospects of Iceland tremendously! We have plenty of energy that can be used to fuel the car fleet of Iceland instead of running aluminium smelters. The net savings of foreign currency (less imports of oil-based fuels) and the consequential easing on the balance of payments constraint would be most welcome.

Other industries are waiting to expand and their expansion would be very beneficial for both the level of employment and the balance of payments: beer and alcohol brewing; computer games and other IT industries; and product development in food stuffs, especially fish and sea food, just to name a few.

But small industries need low level of uncertainty and access to cheap but steady supply of financial capital. And given the high level of uncertainty that is caused by the amount of capital that wants to get out of the economy ASAP, thereby killing the exchange rate and all cost-plans associated with real capital investments but only held back by the capital controls, we cannot be surprised that the level of investment is so low. What has killed investment in Iceland is uncertainty and that uncertainty is caused by the fact that still today, five years after the collapse in 2008, we do not know what will happen to the leftovers of the Icelandic pre-2008 boom. Those leftovers - financial capital - are waiting to get out but held back only by the capital controls.

There are general elections in Iceland tomorrow, Saturday. The most prominent problem of the post-elections government will be to fix the underlying problem of financial capital that awaits its chance to get out of the economy. While that problem is left on the table, employment, investment and the standard of living will not improve.

And beware, there are no easy ways out. Cheating on the problem by either pretending that it does not exist or by assuming that building another smelter - as some politicians unfortunately want to - will fix it will in fact not as what is needed is a long-term sustainable solution where other economically and environmentally friendly industries can maintain the level of investment; building a smelter without fixing the overhang of capital waiting to get out would be like putting a band-aid on a gunshot wound.

So I only have one plea to make to the future government of Iceland: fix the overhang of capital waiting to get out of the economy, get the level of uncertainty down and support small industries in their investment projects. Do this and you will probably be re-elected.

Islandsbanki's incredible profits

Mbl.is has a story that appears today, 20 April, saying that Islandsbanki, the bank which was founded on the ashes of the old and bankrupt Glitnir bank, has written of 475 billion ISK of customers' loans since it was founded, i.e. in October 2008.

Now, no matter how you look at this, 475 billion ISK is a lot! The GDP of Iceland is around 1,700 billion ISK. So this bank alone has written of debt amounting to 28% of GDP. If we look at the balance sheet of Islandsbanki we learn that its total assets were, at year end 2012, worth 823 billion ISK. That compares to 658 billion ISK in total assets at year end 2008. If we simply assume that the bank has written off just over 100 billion ISK per full year it has been running since 2008, we come to the conclusion that it has written off customers' debt (which are, of course, the bank's assets) worth roughly 1/8 - 1/6 of its balance sheet every year.

What further adds awe to those debt write-off figures is the fact that while the bank has written off 475 billion ISK its net profit after taxes amounts to 93 billion ISK since 4Q2008 until year end 2012.

This is truly amazing! A bank which, every year, writes off debt equal to maybe 12-17% of its total assets but profits at the same time. The figures for the other two major banks - Arion bank and Landsbanki - are similar.

The reason for those amazing figures is the endowment which the banks got at their births. When the Icelandic banks were re-established on the ashes of the old ones in October 2008, their domestic debts (customers' deposits were probably the most important ones) were transferred, intact, from the balance sheet of the bankrupt banks onto the balance sheet of the new ones. In the case of Islandsbanki, it took over the domestic liabilities of Glitnir.

To meet those liabilities, the new banks got domestic assets - consumers' loans, mortgages, corporate loans, etc. - transferred as well. However, knowing that there would be a massive hit on the ability of the debtors to repay those loans, they were transferred with a discount off their face value: a corporate loan of 10,000,000 ISK (face value, i.e. what was written on the debt contract behind the loan) became 6,000,000 ISK on the balance sheet of the bank.

I do not think that anybody truly knows what the discount truly was, the 40% discount here is only an example. But whatever the discount was, it is blatantly obvious on the aggregated balance sheet of the financial system. The figures here below are based on data coming from the Central Bank of Iceland.

Total book-value of loans to domestic parties, all deposit-institutions (mainly banks), ISK, millions.

Notice the drop. It is in October 2008. Somehow, magically, the debt of Icelandic households and companies decreased from 4,891 billion ISK in September 2008 down to 2,177 billion ISK in October 2008. The reason, of course, is that those figures show the book-value of loans and not the nominal value, i.e. the face value of the debt. This easily shows that when the new banks were established in October 2008, they received a huge book-value discount compared to the face value of loans.

This discount has not only been used to write off debt but to show an accounting profit as well. In the case of Islandsbanki, that debt write off is 475 billion ISK since its foundation. This is as expected, nobody ever expected that firms and households would be able to repay the whole face value of their debts. But in the case of its profits, the bank has been able to revalue the book-value of its loans back up towards the face value, showing an increase in assets which is booked as positive revaluation of its asset portfolio, consequently showing a profit. This is why the bank has been able to write off 475 billion ISK since October 2008 while showing a 93 billion ISK profit at the same time.

One would think that writing off debt would ease the debt burden for the debtor. That is of course true. The bad news however is that only a handful of debtors have received too-large majority of the debt write offs, thereby skewing the positive economic effects of debt write offs. The BBC equivalent in Iceland, Ríkisútvarpið, explained already more than a year ago that although, back then, 750 billion ISK had been written off of loans, only five companies got 208 billion ISK written off while all the households got, total, 196 billion ISK written off. Not to mention that the owners of those five companies were familiar faces which many had political and bank-related connections. It's good to have friends!

In the case of Islandsbanki, the bank has now written off 103 billion ISK of households' debt while corporations have gotten away from 372 billion ISK. Much of those write offs have been due to the fact that exchange-rate-indexed loans, which were made looking like they were loans in foreign currencies, were deemed illegal by the supreme court. Consequently, those loans, which amounted to billions, had to be written off or corrected. Of those 372 billion ISK, only 32 billion are due to illegal loans. Most of the rest (319 billion ISK) have been reached through "agreements with Islandsbanki". Of course, we can expect some of those contracts to include e.g. debt-for-equity swaps.

Understandably, the inequality in how write offs took place - only a few (in)famous individuals got most of them - made a spark which is now turning into a flame engulfing the whole blogosphere and the news. The result is that one of the hottest promises before the general elections, which will take place on 27 April, is debt write offs to the households. Majority of parties have promised debt write offs to households and those which do not have been rejected by voters, polls show.

We'll see how that ends. When I was young I learned that the word "politican" is a nine letter word describing an individual who says one thing but does the other.